Raid!

There is an old Wall Street adage that is apt for both 2008 and 2009: “When they raid the whorehouse, they take the charwoman and piano player too.” Translation: when the stock market panics, it doesn’t have time to distinguish between the naughty and the nice, between the innocent and not-so-innocent. They are all piled into the paddy wagon and hauled off to the pokey. It’s like that with stocks of big financial institutions in today’s mortgage crisis. Nobody knows what the mortgage-related paper these banks hold is worth. So the market knocks almost all of these stocks down mercilessly.

This causes a lot of unhappiness but also brings opportunity. At some point, somebody will recognize that the market has been punishing the charwoman and the piano player, who aren’t burdened with much lousy mortgage paper. Their stocks will rebound, while the stocks of the wicked remain in the hoosegow.

This year and next, there is a perfect market and economic environment for betting on charwomen and piano players, although this can be a speculative game. The stock market will be highly volatile, as it was in 2007. Categories of stocks will be in favor one day and out of favor the next. That means more raids and more eventual exculpation of the innocent.

Such market volatility feeds on uncertainty, and the U.S. economy will provide that in spades. There is a 35 to 60 percent chance of a national recession, caused by the mortgage and real estate crisis and the damage it is doing to consumer spending, which is 70 percent of the economy. (San Diego’s recession odds are about 80 percent; it may already be in recession, because the real estate chaos will be more intense than in the rest of the nation.) Recession or not, there is agreement that the U.S. economy will soften noticeably. The nation may be only halfway through the housing pain; San Diego, where prices have already fallen 15 percent from the peak, has even further to go. The bulk of corporate profits will weaken. Overseas economies may stay strong, generally.

And that’s where the uncertainty lies. The dollar has plunged 30 percent against other currencies. The countries behind those currencies, particularly the euro, aren’t happy about this dollar weakness. Those countries’ export businesses are hurting. They would like to see the euro weaken against the buck.

But the U.S. Federal Reserve is fighting a recession. The usual cure is liquidity. Lending is frozen by the mortgage crisis. A little monetary juice may loosen things up. The Fed is expected to lower interest rates and, through its daily open-market operations, pump liquidity through the banking system.

Problem: more liquidity weakens the currency even more because lower interest rates make dollar-denominated assets less attractive. A weaker currency and a flood of liquidity lead to even more inflation. For example, the weaker dollar leads to higher prices of imports. When import prices rise, domestic producers have an excuse to raise their prices.

So we have monetary inflation — the kind that is created by central banks, in effect, printing money. But we also have nonmonetary inflation. Food prices, in particular, are going up for other reasons. Until a couple of years ago, food prices were going down. No more. Globally, wheat prices have doubled since spring. Other agriculture commodities’ prices have been soaring. “Dearer food is likely to persist for years,” says the Economist magazine, which labels the phenomenon “agflation.” Among the many factors tipping the supply/demand balance toward higher prices: the amount of meat a Chinese person eats each year is now 150 percent higher than it was in 1985. America’s subsidization of ethanol will use up one-third of the corn crop. Result: higher corn prices. And fuel inflation will probably remain high.

Consumer inflation is now running at 4 to 5 percent and may be at 6 percent or higher by year-end. This is beyond the Fed’s tolerance limits and will inhibit its ability to fight recession with lower interest rates and more monetary juice. The Fed will look for creative, low-key ways to pump liquidity into the banking system. Other countries will do the same to lower their currencies, as they are doing now. The world’s central banks will say these are coordinated efforts to melt frozen global credit markets, but that may not be what’s going on: nations may be trying to whack their own currencies — something similar to competitive devaluations.

Just imagine the volatility. Today, analysts are sure that because of the weak dollar, the stocks to buy are the ones that sell products overseas: Caterpillar, General Electric, Boeing, Coca-Cola, etc. Those stocks will probably rise in this environment. Then suppose the dollar starts rising. Raid! These stocks will be hauled off to the slammer.

One day, certain stocks will be in jail, and the next, in favor. The overall market could crash this year, or it could go up, at least moderately. It is not as tied to the economy as it once was, because fiscal and monetary policies are obsessively devoted to keeping stocks up. Even though earnings may crater, the market could continue to be buoyed by liquidity. Just watch out if the Fed can no longer pump in the juice and interest rates soar with inflation. Bonds will fall in price. The only place to hide will be money market funds, savings instruments, and commodities (but be wary of those shark-filled commodity pits).

Since the government is holding a gun to your head and telling you to buy stocks, you really should own some. One way to hedge is to buy stocks of recession-proof companies making consumer essentials that also have a big overseas presence. There are two jewels: Procter & Gamble and Johnson & Johnson. Since the tax on dividends is now so low, you can load up on utilities, although steer clear of those trying to diversify out of the basic business. San Diego’s utility, Sempra, yields only 2 percent, but some say its nonutility operations, such as pipelines and liquefied natural gas, give it an excellent future. And there will be some opportunities in big banks once the mortgage threat clears, but that may be some time.